Portfolio Management of Money Market Funds

Chapter 7
Portfolio Management of Money Market

Funds
Conditions for Stable $1 NAV
Money market funds may maintain a stable $1 NAV if

they meet the tests set out in SEC Rule 2a-7.
– If they meet these tests, they may use amortized cost accounting to
compute their NAV.
– Amortized cost accounting allows funds to use the price paid for a
security (rather than current market value) in the NAV calculation.
A stable NAV is reasonable because money market

funds hold securities that are:
– Of very high quality.
– That have only a short time to maturity.
As a result, the odds are high that these securities will

be redeemed at face value.
Rule 2a-7
Rule 2a-7 ensures that money market funds are invested very
conservatively.
• Maturity of single security limited to 397 days.

Maturity • Weighted average maturity limited to 60 days.
Credit quality • 97% in one of top two categories.
• Maximum of 5% of assets in securities of single

Diversification issuer if rated in top two categories.
• Maximum of 0.5% of assets in other issuers.
• At least 10%: daily availability.

Liquidity • At least 30%: weekly availabilit.y
• Maximum 5% illiquid.
Shadow Pricing
The board of directors must compare the shadow price

to the $1 NAV.
– The shadow price is the NAV computed using market prices.
If the shadow price is higher than $1.004 (= above $1

by more than a half a penny)*:
– The board will distribute income to reduce the NAV to $1.
*This is an unlikely scenario because money market funds rarely

realize capital gains.
Breaking the Buck
If the shadow price is lower than $0.995:

– The fund has broken the buck.
– The board will stop using amortized cost accounting and
switch to a market value NAV.
– The board may suspend redemptions so that the fund can
be liquidated in a orderly manner.
Money market funds have broken the buck only twice.
– Community Banker’s U.S. Government Money Market Fund
(1994)
– Reserve Primary Fund (2008)
– Fund management companies may provide financial support
to keep funds from breaking the buck.
Directors’ Duties under 2a-7
• Monitor shadow pricing and take action if it deviates

from $1 by more than half a penny.
• Monitor credit quality and confirm that manager’s
research practices are rigorous.
• Review policies and procedures used to assure
compliance with Rule 2a-7.
• Oversee stress tests that gauge the fund’s ability to
maintain a $1 NAV under certain scenarios.
Holdings in Taxable
Money Market Funds (1)
• Issued by the U.S. government.

Treasury securities • Funds holding only Treasuries are
popular in times of crisis.
• Issued by federal government agencies

or by government-sponsored enterprises,
Agency securities
which include Fannie Mae and Freddie
Mac.
Commercial paper • Issued by corporations, including banks.

Institutional Money Market Fund Assets
2,500
2,000
1,079
1,500 1,187
General-purpose funds
$ billions
1,109
1,000 Treasury and U.S government
funds
820 904
790 748
735 1,204
678
500 513 897
404
576
219 295 299 270 254 274 287

201
0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Source: Investment Company Institute, 2010 Investment Company Fact Book
Holdings in Taxable
Money Market Funds (2)
Certificates of deposit
• Deposits in banks.
(CDs)
• Loans to broker-dealers backed by

Repurchase securities.
agreements
• Very short-term; often overnight.
Holdings in Tax-Exempt
Money Market Funds
• Issued by state and local governments.
• BAN = Bond Anticipation Note
Municipal notes
• TAN = Tax Anticipation Note
• RAN = Revenue Anticipation Note
• Issued by state and local governments.

Commercial paper • Often backed by a letter of credit from a
highly-rated bank or insurance company.
• A long-term tax-exempt bond combined

Variable rate demand with a short-term put option (from a
notes financial institution) that provides liquidity.
Managing a Money Market Fund
Money market fund portfolio managers must balance

two goals:
– Maintaining a stable $1 NAV and assuring liquidity to shareholders.
– Providing a competitive yield.
They must monitor:

– Average maturity of portfolio.
– Allocation among maturities.
– Liquidity.
– Allocation among types of securities.
Money Market Funds vs. Bank Deposits
Money market funds are often used interchangeably with savings
accounts, but there are clear distinctions.
Immediate access to • Provided by both.

funds
Payment of competitive • Provided by both, through different mechanisms.

interest rates
Fed. Deposit
• Carried by bank deposits only.
Insurance Corp. • Money market funds provide security through diversification..
insurance
• Banks have local presence through branches.
Local convenience • Both now provide telephone and online access.
Banking services • Both provide other services such as check-writing.

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Chapter 7

Portfolio Management of Money Market

Money market funds may maintain a stable $1 NAV if

A stable NAV is reasonable because money market

As a result, the odds are high that these securities will

• Maturity of single security limited to 397 days.

Credit quality • 97% in one of top two categories.

• Maximum of 5% of assets in securities of single

• At least 10%: daily availability.

The board of directors must compare the shadow price

If the shadow price is higher than $1.004 (= above $1

*This is an unlikely scenario because money market funds rarely

If the shadow price is lower than $0.995:

• Monitor shadow pricing and take action if it deviates

• Issued by the U.S. government.

• Issued by federal government agencies

Commercial paper • Issued by corporations, including banks.

219 295 299 270 254 274 287

• Loans to broker-dealers backed by

• Issued by state and local governments.

• A long-term tax-exempt bond combined

Money market fund portfolio managers must balance

They must monitor:

Immediate access to • Provided by both.

Payment of competitive • Provided by both, through different mechanisms.

Banking services • Both provide other services such as check-writing.

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